Debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of a company or not as defined in section 2(12) of the Companies Act, 1956 ("the Act"). This is an inclusive definition and amounts to borrowing of monies from the holders of debentures on such terms and conditions subject to which the debentures have been issued. Basically the debenture is represented by a document or certificate signed by the authorized officers of a company acknowledging money lent and guaranteeing repayment with interest and with or without security on the assets of the company for due performance of its obligation. This is a debt instrument and is the commonest method of raising loan capital at a lower cost, as part of project financing or for any other purposes.
Debentures may be redeemable as envisaged in the Act or mandatorily convertible wholly into the equity shares of a company as envisaged under FEMA. While the articles of a company should contain an enabling provision for issue of debentures and creation of security thereof by the Board, the quantum of such issue should be adequately covered by a borrowing resolution of its shareholders under section 293(1)(d) of the Act. Debentures may be fully or partly convertible or non convertible as per the terms of the issue.
2. Issue of Debentures & creation of Security:
A company which issues debentures is under an obligation to create security thereof pursuant to section 117A of the Act by executing a trust deed. The need for executing a trust deed will arise when a company wants to issue a prospectus or letter of offer to the public for securing subscription to its debentures and for this purpose appoint one or more Debenture Trustees.The trust deed should state that the Debenture Trustees have consented to be appointed as such as required by section 117B of the Act. Thus a Debenture Trustee enjoys a unique position of being an independent entity unconnected with the issuer of security but none- the- less appointed to protect the interest of holders of debentures.
3. Qualification for Appointment of Debenture Trustee:
All and sundry cannot be appointed as Debenture Trustees. A person holding beneficially shares in the issuer company or beneficially entitled to receive moneys from that company and has provided any guarantee in respect of principal debts secured by the debentures or interest thereon as specified in section 117B of the Act. SEBI (Debenture Trustee) Regulations, 1993 additionally prescribe that no person shall be entitled to act as Debenture Trustee unless he is either a scheduled bank carrying on commercial activity or a public financial institution within the meaning of section 4A of the Act or an insurance company or a body corporate. It is also necessary that such an entity should have capital adequacy of net worth of one crore of rupees and have been licensed by SEBI to act as a Debenture Trustee.
4. Functional Role of Debenture Trustee:
The Debenture Trustee is an intermediary between the issuer of debentures and the holders of debentures. Accordingly the main responsibility of debenture trustee is to protect the interest of holders of debentures including creation of adequate security by the company issuing the debentures and to redress their grievances. He may also take such steps as he deems fit to:
Under the Act:
- ensure on a continuous basis that the assets o f the company issuing debentures and each of the guarantors are sufficient to discharge the principal amount and the interest at all times;
- to satisfy himself that the prospectus or the letter of offer does not contain any matter which is inconsistent with the terms of debentures or with the trust deed;
- to ensure that the company does not commit any breach of covenants and provisions of the trust deed;
- to take such reasonable steps to remedy any breach of the covenants of the trust deed or the terms of issue of the debentures;
- to take steps to call a meeting of holders of debentures as and when such meeting is required to be held.
Needless to say, that the aforesaid responsibilities are intended to protect the interest of the debenture holders. One of the aforesaid requirements relate to adequacy of security so that in the event of failure of issuer of security to redeem the debentures, (which is an event of default) the Debenture Trustee should enforce the security and pay off the debenture holders by disposing off the secured assets.
Under aforesaid Regulation:
Regulation 15 of aforesaid Regulation prescribes the duties of the Debenture Trustee, inter alia, as under:
- call for periodical reports from the body corporate i.e. issuer of debentures;
- take possession of trust property in accordance with the provisions of the trust deed;
- enforce security in the interest of the debenture holders;
- ascertain and satisfy on a continuous basis that the property charged to the debentures is available and adequate at all times to discharge the interest and principal amount payable in respect of the debentures and that such property is free from any other encumbrances save and except those which are specifically agreed to by the debenture trustee;
- exercise due diligence to ensure compliance by the body corporate with the provisions of the Act, the listing agreement of the stock exchange or the trust deed;
- to take appropriate measures for protecting the interest of the debenture holders as soon as any breach of the trust deed or law comes to his notice;
- to ascertain that the debentures have been converted or redeemed in accordance with the provisions and conditions under which they are offered to the debenture holders;
- inform the Board immediately of any breach of trust deed or provision of any law;
- appoint a nominee director on the board of the body corporate in the event of:-
i) two consecutive defaults in payment of interest to the debenture holders; or
ii) default in creation of security for debentures, or
iii) default in redemption of debentures.
- no debenture trustee shall relinquish its assignments as debenture trustee in respect of the debenture issue of any body corporate, unless and until another debenture trustee is appointed in its place by the body corporate.
Regulation 17A of the aforesaid Regulation provides that every debenture trustee should appoint a "compliance officer" and he shall be responsible for monitoring the compliance of the Act, rules and regulations, notifications etc issued by the Board or the Central Government for redressal of investor's grievances. Thus a Debenture Trustee occupies a pivotal position of trust and confidence between the company which issues debentures and the debenture holders who subscribe to the debentures. ulations and he shall be responsible for monitoring teh snditions under which they are offered
5.Contents of the Debenture Trustee Agreement:
Schedule IV to the aforesaid Regulation lists some of the clauses which are to be included in the Debenture Trustee Agreement. They are:
- Description of the Instrument
- Details of charged securities i.e.
- nature of charge
- examination of title
- rank of the charge i.e. whether first, second, or pari passu charge etc
- charging of future assets
- time limit for creation of charge
- minimum security cover required
- valuation of security
- circumstances in which security becomes enforceable
- method and preservation of secured property etc
- Events of default
- Rights of Debenture Trustee
- Obligations of the body corporate (i.e. Issuer of debentures)
Apart from the above, the Debenture Trustee Agreement will have to include the following provisions:
- Definition and Interpretation
- Appointment of Debenture trustee and its powers
- Remuneration of Debenture Trustee
- Appointment of debenture Trustee as Attorney
- Negative pledge i.e. not to creation additional encumbrances on the secured asset,
- Description of Events of Default, this may arise due to non-payment to debenture holders, breach of any undertaking, avoidance or repudiation
- Notice of exercise of trustee powers
- Indemnity of trustee
- Retirement of trustee & appointment of new trustee
- Reimbursement of expenses incurred by the trustee
- General covenants etc
6. Who can appoint Debenture Trustee?
Creation of security means mortgaging or charging the property in favor of Debenture Trustee for the benefit of debenture holders. This is an incidence of ownership of property and creation of security has to be done by the owner of the property. However, the debenture holders are beneficiaries and they have no access to mortgaged property. The Debenture Trustee holds the secured property on behalf of issuer of security and for benefit of debenture holders. In the event of default by the issuer of security, the Debenture Trustee will have the power and authority to bring the secured property to sale following the procedure in the Transfer of property Act, 1882 and the proceeds of sale will have to be applied to redeem the debentures. This is one of the onus conferred on the Debenture Trustee by the aforesaid regulation. Effective use of this power is possible if it is included in the Debenture Trustee Agreement and a suitable power of attorney is executed by the issuer of debentures in favor of Debenture Trustee. This document has to be executed as a trust deed and not as a Mortgage deed or bond.
7. What if the debenture holder is a non-resident?
These days' big real estate development projects are financed by international banking Institutions under the Special Economic Zone (SEZ) by subscribing to mandatorily convertible debentures, as required under the FEMA. In such an event if the debenture holder is a non-resident, he cannot hold the mortgaged property as FEMA regulation prohibits a non-resident holding an immovable property in India. Definition of "transfer" in section 2(ze) of FEMA includes sale, purchase, exchange, mortgage, pledge, gift, loan or any other form of transfer of right, title, possession or lien. However, a non-resident debenture holder requires back up security till his debentures are converted into the equity shares of the Indian company. This can be achieved by appointing a Debenture Trustee so that he will be able to hold the secured property for the benefit of non-resident debenture holder. This does not attract FEMA provisions as the secured property is held by an Indian entity on behalf of an Indian company. Even the sale of secured property by the debenture Trustee, in the event of default by the Indian company will not attract FEMA provisions as the transaction will take place in India without the involvement of non-resident debenture holder. However remittance of sale proceeds to the non-resident debenture holder involves FEMA scanner and debenture age and will have to be routed through the authorized dealer in foreign exchange as there is no automatic capital convertibility.
8. Should Debentures be fully secured?
This is one of the vexed issue regarding the issue of debentures. There is divergence of views in this regard. Debenture is defined in Sec 2(12) of the Act as including debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of the company or not. This is an inclusive definition .and does not define what is debenture. Of course in commercial parlance it is generally understood as borrowing of funds under certain terms and conditions represented by the debenture certificate.
The definition of "debenture" enacted in the year 1956 when the present Act came on the statute book creates an impression that a debenture may or may not be secured. It follows from this if it is secured, the provisions of section 125 of the Act will apply requiring registration of charge with the ROC. If it is not secured, then it will not get the benefit as an exempt deposit. Under Rule 2(b)(x) of the Companies (Acceptance of Deposits) Act, 1975 and Part 3 of the Return of Deposits (which lists out particulars of exempt borrowings etc not considered as deposits) item 9 thereof describes "money received by issue of debentures secured by mortgage of immovable properties or convertible debentures is shown as exempt deposit".
9. What are the consequences of issuing unsecured debentures?
A plain reading of sections 117A and 117B of the Act makes it clear that creation of security is a must in the case of issue of prospectus and letter of offer to the public.. Where no charge is created the issuer company will have to comply with the provisions of the Companies (Acceptance of Deposits) Rules, 1975 as unsecured debentures\bonds are treated as "deposits". SEBI revised guidelines is silent on this aspect but none-the-less the provisions of the Act will apply to the listed companies.
The NBFC Acceptance of Public Deposits (Reserve Bank) Directions, 1998 provide that "any amount received as hybrid debt or subordinated debt the minimum maturity Period of which is not less than 60 months" is an exempt deposit.
The Companies (Amendment) Act, 2000 which came into force from13-12-2000 has introduced a few special Provisions exclusively applicable to debentures in sections 117 to 123 to the Act. A trust deed for securing any issue of debentures is required to be executed as envisaged in section 117A of the Act implying thereby that any issue of debentures should necessarily be secured. Security creation is a must for a public or rights issue o f debentures and this has been done for protection of interest of debenture holders.
10. Manner of creation of Charge:
A charge for securing any issue of debentures is considered as a charge within the meaning of section 125 of the Act. It envisaged various types of charges. The nature of charge created differs from company to company and every company has a choice as what it would like to offer as security to the debenture holders. However the security offered should be adequate to meet the financial obligation to the debenture holders. Registration of charge will make the debenture holders secured creditors of the company and as such they have priority claim on the secured property. A charge on immovable property requires registration not only under the Act but also under the Registration Act. This may also include a charge created by way of conditional sale of any immovable property.
The creation of charge may be by way of fixed charge or a floating charge or both. A charge becomes fixed with reference to the specific property on which charge is created and the company which creates such a charge has to deal with the property subject to charge. On the other hand, a floating charge is a charge over all the assets, properties and the company may deal with such property in the ordinary course of business in any manner until the charge attaches.
However, whether a charge is "fixed" or "floating" has to be determined by the substance of the transaction and not by the description used by the parties in the agreement creating the charge. A floating charge becomes a fixed charge when the debtor company ceases to carry on its operations or goes into liquidation.
There are a number of court decisions determining the nature of charge. A charge which purports to cover future book debts is held to be a floating charge by the very nature of the charge and not a fixed security. In another case, the debtor company created a fixed charge on its"book debts", the court held that the charge remains a fixed charge as long as the debt remained uncollected and a floating charge on collection. This is based on the view that the company continued to have right to collect the debts and appropriate the proceeds. The classification of charge as fixed or floating becomes important and serious when the company goes into liquidation when the determination of ranking of debts has to be done for payment out of the proceeds of the property.
In the case of multiple charges on the same property, there is need for determination of ranking of the charge. A registered charge takes priority over the un-registered charge, whether it be previous or subsequent to the unregistered charge.
11. Can a private company issue debentures & appoint debenture trustee?
A private company is prohibited from inviting public to subscribe to its shares or debentures. However, nothing prohibits the company from issuing debentures on private placement basis, if the Articles of the company empowers the Board to borrow by issuing debentures and creation of security. All other provisions of the Act as applicable to a public company will apply except that it may not be required to appoint Debenture Trustee. The company may execute a deed of charge on its assets and register it with the ROC and this is permissible under section 117B of the Act. The requirement of having to create Debenture Redemption Reserve (DRR) will have to be followed as section 117C is a special provision applicable to all companies. This is however subject to relaxations provided in respect to certain categories of companies by the DCA vide its circular No9\2002 dated 18-4-2002.
12. Can a Company create security on future assets or future receivables?
Section 125 of the Act envisages various types of charges including in particular a charge on the uncalled capital of the Company, a charge on calls made but not paid etc,. Future receivables form part of sundry debtors which keeps fluctuating from year to year and in the case of properties it may consist of existing assets or any accretion thereto from time to time. What is important is the intention of the parties in creating the charge and the extent of operation of such charge.
13. Can an unlisted public company issue debentures?
Issue of debentures means exercise of borrowing powers. Therefore, it necessarily follows that the total value of debentures including other borrowings should be well within the borrowing limit fixed by the shareholders by a resolution under Section 293(1)(d) of the Act. The Articles should also authorize the board to offer the assets of the company as security to the debenture holders. If the security creation falls within the ambit of section 293(1)(a) of the Act encompassing the whole or substantially whole of the assets of the undertaking by way of sale, lease or otherwise in the event of default, then the approval of the shareholders will also be required for creation of security.
14. Additional compliances in the case of a listed company
SEBI (Disclosure &Investor Protection)Guidelines,2000 (DIP guidelines) has been replaced by SEBI(Issue & Disclosure Requirements) Regulations,2009(ICDR) and it seeks to simplify capital issue requirements for protecting the interests of investors in securities .The new guidelines have been issued under section 30 of the SEBI Act which empowers the SEBI to make regulations for carrying out the purposes of the Act and in particular section 11A of the SEBI Act. This provision empowers SEBI to regulate or prohibit issue of prospectus, offer document or advertisement soliciting money for issue of securities..
A listed company is required to follow SEBI 2009 guidelines as applicable to debt instruments, in addition to the provisions of the Act. No listed company is permitted to issue convertible security unless it has complied with the requirements of the Companies Act."Convertible Security" is defined as a security which is convertible into or exchangeable with equity shares of the issuer at a later date, with or without the option of the holder of the security and includes convertible debt instruments and convertible preference shares(SEBI guidelines).. No debenture is permitted in the case of a listed company for acquisition of shares or providing loan to a company belonging to the same group. This stipulation does not apply to the issue of debt instrument having a conversion period of less than 18 months.
The aforesaid Regulations specifically provide for the following types of debt instruments;
- Rollover of non-convertible portion of partly convertible debt instruments the value of which exceeds Rs 50 lakhs. The roll-over may be done without changing the rate of interest if 75% of the holders of security approve the roll-over through the postal ballot. The issuer should redeem the debentures, if any holder of such security does not consent for the roll-over;
- Conversion of optionally convertible debt instrument into equity capital with the positive consent of holders of such security. Where the value of security exceeds exceeds Rs 50 lakhs and the issuer has not determined the rate of conversion, the holder of such security should be given an option of not converting such security. Where an upper limit of price has been determined by the issuer and disclosed to the investors, the option aforesaid need not be given.
Chapter VIII of the above guidelines deals with private placement of securities with Qualified Institutional Placement(QIP's).The eligible securities include, inter alia, non-convertible debt instruments along with warrants and convertible securities other than warrants.
Another regulation relates to credit rating of the debt instrument. No company is permitted to make a public issue or rights issue of debt instruments, whether convertible or not, unless credit rating of not less than investment grade is obtained from not less than two registered credit rating agencies and disclosed in the offer document.
15. Stamping Requirements:
In the matter of issue of debentures, Mortgage Deed ( Article 40) and Debenture ( Article 27) has been dealt with in the Indian Stamp Act. While the former document sets out the terms and conditions subject to which debentures have been issued security, the latter document provides for transfer of debentures as a marketable security. There are various forms for creation of security by way of mortgage. It may be with possession or without possession of Property with reference to which mortgage has been created or proposed to be created. One of the simplest ways of creating mortgage is by deposit of title deeds in respect of secured asset and this has been dealt with in Article 6 o f the Indian Stamp Act. Where the debt is repayable on demand or more than three months from the date of the instrument evidencing the agreement, the stamp duty payable is the same as on the bill of exchange dealt in Article 13(b) of the said Act. Accordingly, upto rupees one thousand, it is five rupees and for every additional one thousand or part thereof, the duty payable is rupees five. Where it is payable more than one year after date, the amount of duty payable will have to be worked on the total value of debentures.
Article 27 deals with stamp duty payable on the transfer of debentures as a marketable security by way of endorsement or by separate instrument of transfer. Rates of stamp duty are given in the Article. However, in the matter of issue of debenture certificate, there is an exemption. This exemption is applicable if the debenture certificate is issued by an incorporated company in terms of registered mortgage deed, duly stamped in respect of full amount of debentures and the debenture certificate is issued pursuant to the said mortgage deed. The proviso to Section 3 of the Indian Stamp Act which deals with liability of instrument provides that no duty shall be chargeable in respect of any instrument executed by or on behalf or in favor of the Developer or Unit or in connection with the carrying out of purposes of the Special Economic Zone.
Section 8 of the Indian Stamp Act provides for a duty of one percent of the total value of debentures, Bonds or other securities issued by a local Authority for raising loan under the provisions of Local Authorities Loans Act, 1879 or any other law for the time being in force and such bonds, debentures or other securities need not be stamped and they are not chargeable with any further duty on renewal, consolidation, sub-division or otherwise. There is also duty exemption in the case of issue of securities to the depositories under the Depositors Act including transfer of such securities.
In the Karnataka Stamp Act, 1957 item 6 of the schedule deals with agreement relating to deposit of title deeds, pawn or pledge, that is to say, any instrument evidencing where such deposit has been made by way of security for repayment of money advanced or to be advanced by way of loan or existing or future debt, the stamp duty payable is rupees 50 for an amount exceeding rupees 10,000 (if drawn singly) or Rupees 25 (if drawn in set of two ,for each part o f the set) and for additional 10,000 or part thereof in excess of Rs10,000,it is Rs 25 (if drawn singly) or Rs12-50 (if drawn in more than one set).This applies where the debt is repayable on demand or more than three months from the date of instrument evidencing the agreement.
The Stamp duties are a tax on transactions. While the rates of duties on instruments of commercial nature are prescribed by the Union Govt for the sake of uniformity, the rates of duties on other instruments are prescribed by the state legislature in respect of States having their own stamp acts.
Payment of stamp duty is incidental to acquisition or transfer of property. Sometimes companies get the Instruments stamped in the State where the stamp duty is comparatively low to save on cost, though the property may situate in another state. This may not work out in a beneficial manner. The Indian Stamp Act by section 3 which deals with instruments chargeable to duty, inter alia, provides that (a) every instrument mentioned in the schedule which, not having been previously executed by any person, is executed in India on or after first day of July 1899 and(b) every instrument mentioned in the schedule which, not having been previously executed by any person in India, is executed out of India on or after that day, relates to any property situate or to any matter or thing done or to be done in India and is received in india are liable to stamp duty. A similar provision is there in the Karnataka Stamp Act.
16. Debenture Certificate:
The debenture certificate stands on a different footing. Before issue of certificate, the company will have to create a charge on the assets of the company by filing the required forms with the ROC. The certificate of charge will have to be reproduced on the back of the certificate as also major terms and conditions subject to which debentures have been issued. Section 113 of the Act provides for issue of debenture certificate within three months from the date of allotment of debentures. However, the Company Law Board (this power is being shifted to Central Govt) may extend the period to a further period not exceeding nine months if it is satisfied that the company is not in a position to deliver the certificate within the aforesaid period of three months. Delay in creation of security may be one of the reasons for seeking extension of time.
17. Debenture Redemption Reserve (DRR):
Section 117C of the Act requires that every company issuing debentures should create DRR for the purpose of redemption of debentures to which adequate amounts should be credited from the profits of the company until debentures are redeemed. This is a mandatory provision. SEBI regulations also require companies issuing debentures to provide for DRR as required under the Act. Even where debentures are compulsorily convertible into the equity shares of the debenture issuing company, as in the case FEMA, creation of DRR is unavoidable till the date of conversion. However, after conversion of debentures, the amount in the DRR may be transferred to general reserve or in such other manner as the Board thinks fit and proper. The amount credited to DRR cannot be utilized except for the redemption of debentures. DCA Circular NO 9 \2002 dated 18-4-2002 provides some relief as under in the matter of DRR in the case of banking Institutions, All India Financial Institutions, NBFC's and others keeping in view the genuine problems likely to be caused to these institutions:
a) No DRR is required for debentures issued by All India Financial institutions(AIFI's) regulated by RBI and banking companies for both public as well as privately placed debentures.. For other FI's within the meaning of section 4A, DRR will be as applicable to NBFC's registered with RBI;
b) For NBFC's registered with RBI under section 45-1A of the RBI(Amendment) Act,1997 the adequacy of DRR will be 50% o f the value of debentures issued through public issue and no DRR is required in the case of privately placed debentures;
c) For manufacturing and infrastructure companies, the adequacy of DRR will be 50% of the value of debentures issued through public issue and 25% for privately placed debentures;
d) Section 117C will apply to debentures issued and pending to be redeemed and such DRR is required to be created for debentures issued prior to 13-12-2000 and pending redemption subject to clarification issued herein;
e) Section 117C will apply to non-convertible portion of debentures issued whether they are fully or partly convertible.
By another circular issued by DCA vide circular NO 4\2003 dated 16-1-2003 the requirement of DRR has been modified in the case of Housing Finance Companies. .In the case of these companies registered with National Housing Bank under Housing Finance Companies (NHB) Directions, 2001, the adequacy of DRR will be 50% of the value of debentures through public issues and no DRR is required in the case of privately placed debentures.
It is also clarified by the DCA that since DRR will have to be carved out of profits of the company, there is no obligation to create DRR if there is no profit in a particular year. DRR is insurance and it enables the issuer of security to redeem the debentures and fulfill its obligation. If, for any reason, the issuer of security fails to redeem the debentures, the aggrieved party may approach CLB\Tribunal which will issue a direction to the company to redeem the debentures forthwith together with interest. Failure to do so is punishable with imprisonment extending upto three years and fine of not less than five hundred rupees for each day of default. (Section 117C of the Act).
18. Unsecured Debentures
Companies may also issue unsecured\subordinated debt instruments\obligations. However, such instruments have to be subscribed by qualified institutional investors or others who have given positive consent for subscribing to such unsecured\subordinated debt instruments. In the case of companies issuing debt instruments like debentures having maturity of less than 18 months, there is a facility of creating a charge on the assets of the company, instead of having to create mortgage and appoint Debenture Trustee for its assets. However, where no charge is created as aforesaid, the issuer company is required to ensure compliance with the provisions of companies (Acceptance of Deposits) Rules as such unsecured debentures\bonds are treated as "deposits".
Sections 117 to 123 o f the Act, 1956 provide for special provisions regarding debentures. These provisions are also applicable to both public companies and private limited companies. The provisions of the articles of the company should also be kept in view. The manufacturing and Infrastructure companies can avail of lower percentage of DRR as the DCA circular does not make any distinction between listed and unlisted companies in its circulars referred to above .and the relaxation is also applicable for privately placed debentures by private companies.
Issue of Debentures, whether redeemable or convertible involves compliance with the substantive and procedural aspects of law. Documentation is equally important. The benefit of raising loan capital lies in the fact that it does not disturb equity structure of the company and consequently the existing management. However, the success of a debenture issue, be it private or public issue depends, to a large extent, on the goodwill and rapport built up by the company with the investing public. Another aspect o f the matter is the protection of interest of debenture holders. This is sought to be achieved by an independent Debenture Trustee who is required to be appointed by listed companies in regard to public issue or further issue of capital as the number of debenture holders are considerably large Creation of DRR which is statutory obligation is intended to provide liquid resource built out of profits of a company for redemption of debentures.
This article has been published by the Eastern Region Council of the Institute of Company Secretaries of India and they retain the copy right of the article
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.